Is this market headed for a correction?

Commentary: What to make of high-profile investors turning bearish

The market’s recent strong run has brought out the buyers, but also the bears — with a growing number of high-profile investing pros suggesting the better-than-expected results and a return to record high territory is leading lambs to slaughter.

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If ever there was a time when playing both sides against the middle would seem smart, it's now. MarketWatch's Chuck Jaffe joins Markets Hub.

On Monday, Pimco’s Mohamed El-Erian wrote in a note that investors should be cautious in the face of the recent rally, arguing the market has been buoyed by central bank policy. (See: El-Erian: Perspective on Dow 14,000) His better-known colleague Bill Gross has been tweeting his skepticism about the Fed, suggesting that investors might want Italian bonds rather than U.S. stocks. See: PIMCO’s Gross says buy Italian bonds

Meanwhile, Jim Shepherd of the Shepherd Investment Strategist newsletter – who tends to be bearish during the best of times – said on my show recently that the Federal Reserve has now created “the most gigantic bubble in history,” noting that a change is inevitable, and likely coming soon. “People have come to the conclusion now that the market will continue to rise for as long as the Fed is in the game, and I think that’s a very dangerous concept to hold,” Shepherd said.

Reuters

With the Standard & Poor’s 500-stock index
SPX, -0.23%
up nearly 6% this year, and 12% over the past 12 months, the question for regular investors is whether to follow the herd, or run from it. After all, history shows that optimism typically rises in the crowd at the worst possible time.

Ultimately, the questions being raised are a reminder that, for most people, the decision should be less about being in or out of the market than about diversifying. To see why investors might want to check their diversification, let’s look at the numbers that suggest they are changing their allocations now, and then at warnings against doing just that.

Research firm Lipper Inc. reported $34.2 billion in net deposits into stock mutual funds and ETFs over the four weeks ended Jan. 30, the largest four-week total since January 1996. Several other industry researchers also reported high levels of cash flowing into stocks as the market climbed to five-year highs.

January marked the first time in 11 months that deposits into domestic equity funds exceeded withdrawals.

There is no shortage of experts expecting the money to keep rolling in to stock funds in the coming months. Backing up that likelihood are several sentiment surveys. The American Association of Individual Investors, for example, notes that bullish sentiment – the expectation that stock prices will rise over the next six months – is above its historical average, as it has been for nearly three months now.

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For the better part of the last two years, despite historic lows in interest rates, cash has been flooding into bond funds, with investors choosing safe havens over bargain stock prices. That’s ignoring the “buy low” part of the classic “buy low, sell high” mantra for making money in the market over time. In fact, it’s turning that equation on its ear, something investors do a lot.

A new study by Russel Kinnel, director of fund research at fund tracker Morningstar Inc., sheds new light on just how badly most investors do when it comes to moving their money around. Over the past decade, Kinnel found that the average mutual fund returned 7.05%, but that the average investor – based on asset-weighted returns that use the inflows and outflows to see how much of a fund’s performance the shareholder captures – netted 6.10%.

It’s worth considering now because the market has reached this interesting point, the one where many people have seen enough from the 2012 gains and the January five-year highs to be diving back into the market just as many observers now expect a correction.

If talk of a correction is, indeed, correct, then a percentage of the money flowing into the market now will wind up buying at a peak, and the ensuing dive will send some of the newcomers back to the sidelines with a loss. That’s incorrect investment behavior no matter how you define it—buying high, selling lower and then not sticking around to see if the “corrected” market is about to resume its climb. See suckers or saviors: Small investors buy up stocks.

All too often, investors feel like they can’t engage their bullish and bearish sentiments simultaneously, that one feeling must win out over the other. But if ever there was a time when playing both sides against the middle would seem smart, it’s now — when investors don’t want to miss out on the rally while it keeps running but recognize that it can’t go on unabated forever.

For anyone following the crowd into the market now, experts suggest that they need to have a time frame that looks beyond the short-term pressures that might lead to a market adjustment; if they fear that a bubble is about to burst, they need to stay conservative or on the sidelines and make avoiding loss their priority.

Anyone scared to be in the market doesn’t belong there, but has to be willing to sit out a period where the market looks good until the tide changes.

For most, however, the right strategy is going to be a mix of bearishness and bullishness.

Historically savvy average investors have used diversification, putting some money to work to reduce each of those many worries. Some money into the market to take advantage of the opportunity, but some powder kept dry to guard against a market adjustment, and some in safe havens to provide peace of mind.

It won’t necessarily provide the “best” returns, but it’s the correct strategy for someone who sees the bulls running, the bears massing — and wants to peacefully co-exist with both sides.

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